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Rum Taxes and Perverse Incentives

Rum, like all spirits, falls under a federal excise tax of $13.25 per proof-gallon. The federal tax revenue collected from rum produced in Puerto Rico, the U.S. Virgin Islands, or internationally is transferred to the governments of Puerto Rico and the U.S Virgin Islands. This transfer of revenue from the United States back to the location of production is called a “cover-over.”

Puerto Rico and the U.S. Virgin Islands each receive all of the revenue collected from rum produced in their territory. The two countries split revenue from foreign produced rum, based generally on how much rum they produce relative to each other. By producing more rum, each territory has the ability to increase their share of the rum tax.

When rum is produced in the U.S. Virgin Islands they are awarded all of the federal excise taxes collected on that rum. If the rum is produced in Puerto Rico, the U.S. Virgin Islands receive nothing. The amount of rum one country produces relative to the other also determines their share of the tax revenue from international production.

Increased rum production in the U.S. Virgin Islands, relative to Puerto Rico (or vice versa), increases the country’s share of cover-over payments from taxes on foreign produced rum. This strong incentive to boost local production for tax revenue from international production has led to a subsidies war between the two territories.

Over the past decade the U.S. Virgin Islands has steadily increased subsidies to bolster rum production. The island’s native producer, Cruzan, receives a subsidy equivalent to 46.5 percent of the tax revenue collected on the company’s rum. Last month Cruzan told the island’s government they would need larger subsidies to survive.

In 2008 the U.S. Virgin Islands subsidized rum producer Diageo’s move to the island (manufacturer of Captain Morgan). Totaling an estimated $2.7 billion over 30 years, the subsidies include: a new $165 million distillery, “market support payments” to keep prices low for molasses (the main ingredient in rum), 35 percent of what Diageo spends on advertising, a 90 percent income tax break, exemption from property taxes, environmental mitigation supports, and 47.5 percent of all tax revenue collected on Captain Morgan rum. By one estimate, Diageo’s net cost to produce rum is zero.

Compounding perverse subsidy incentives, the rum cover-over program has created budgeting shortfalls. The treasuries of Puerto Rico and the U.S. Virgin Islands are reliant on these federal transfers as part of their yearly revenue.

A 1984 law capped the cover-over of the rum tax at $10.50 per proof-gallon, but since 1993 temporary tax extender legislation has removed this cap. The unpredictable biennial reauthorization process of tax extenders often leaves the territories with uncertain revenues. The U.S. Virgin Islands face a $30 million dollar deficit for fiscal year 2014, due to lower rum revenues, if the federal extenders package is not approved.

Unpredictability of tax extenders is only half of the budgeting uncertainties faced by the island nations. Because the distribution of the rum tax is dependent relative production, when rum production changes so does cover-over revenue. In 2005, the U.S. Virgin Islands received $81.1 million from the cover-over program and Puerto Rico received $419.6 million. In 2012, the U.S. Virgin Islands received $256 million (a significant increase) and Puerto Rico received $376 million (a $43 million decrease).

Contributing to the U.S. Virgin Islands’ increase in cover-over payments, and Puerto Rico’s decrease, was rum producer, Diageo’s, relocation from Puerto Rico to the U.S. Virgin Islands. Fluctuations in rum cover-over payments are the product of shifting rum production from one territory to the other – this wreaks havoc on local budgets.

The unintended consequences of the cover-over program have led both Puerto Rico and the U.S. Virgin Islands to manipulate their economies to maximize federal subsidies. The ensuing subsidies race distorts the economy, creates perverse incentives, and destabilizes local government.

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